America is merely wounded, Europe risks death

We have a glimmer of hope. The key indicators of the US money supply are at
last firing on all cylinders, a dramatic turn for the better that would
normally signal recovery or even a mini-boom within the next six to 12
months.

The EU has brought about the first sovereign default in Western Europe since the Second World War and set a fateful precedent without actually resolving the Greek problem. This is the worst of all worldsPhoto: Alamy

Needless to say, these are not normal times. The US and EU debt crises are feeding on each other in a dangerous synergy, with fears of a fiscal “sudden stop” in Washington causing global risk aversion and aggravating tremors in the Spanish and Italian bond markets. It is a pre-taste of the “catastrophe” predicted by the Fed’s Ben Bernanke if politicians fail to control their passions.

And yet, data from the St Louis Fed show that America’s M2 money supply grew at a 6.4pc annual rate in the second quarter, accelerating to 12.2pc in June. The compound annual rate of change has exceeded 40pc over recent weeks.

The broader M3 indicator (including large savings deposits) is growing at the optimal rate of around 5pc. It has been an uncannily accurate lead indicator at each twist and turn of our economic drama over the past five years, and is telling us now that the Fed’s kindling wood has at last begun to ignite the damp coals of the US financial system. There is no longer a 1930s liquidity trap. We can infer that the housing market may be nearing the end of its deep slump.

The economy is curing itself in time-honoured fashion. Whether this monetary cure will be allowed to run its course depends on politicians in Washington, Berlin, Rome and Madrid.

My recurring nightmare ever since the Western debt edifice began to crumble four years ago is that the denouement would track the events of mid-1931, when leaders failed to reform a destructive fixed exchange system (Gold Standard) and the fuse finally detonated on Europe’s banking system. It was when political blunders turned recession into the Great Depression, and ideology intruded with a vengeance.

The narrative of 1931 is already well-known to readers. France sabotaged a rescue of Vienna’s Credit Anstalt because of strategic disputes with Germany. This set off a financial chain reaction. Frightened markets tested the weak links of the Gold Standard. They withdrew funds from Britain after naval ratings “mutinied” over pay cuts. Contagion spread back to New York. By October 1931 the international system had collapsed, though the full horror did not become evident until the next year. A string of countries retreated into variants of autarky, or fascism, or both. Communists and Nazis together won more than half the seats in the Reichstag election of July 1932.

It is far from clear that the international order is more secure today than it was in the seemingly calm days of May 1931, so one cannot lightly forgive the reckless brinkmanship on Capitol Hill over recent days.

I write before knowing the outcome of weekend talks but we can rule out any form of US default. President Barack Obama can invoke the 14th Amendment in extremis, or issue a Bush-style “Catastrophic Emergency” directive.

The more plausible risk is that the debt ceiling is not raised, forcing a ferocious fiscal squeeze to avoid default. Washington would have to slash spending at an annual rate equal to 11pc of GDP, and do so in a disorderly fashion that would shatter confidence.

There are historical cases of respectable growth following fiscal contractions, not least in Britain after 1932 and 1993, but the scale of cuts needed to close America’s double-digit deficit at a stroke is of an entirely different order. You do not have to be Keynesian to see the dangers of such a violent shock in an over-leveraged economy.

If cuts continued into September without either side blinking, the knock-on effects might rapidly set off serial defaults by states and an implosion of the $2.5 trillion municipal bond market. The bankruptcy saga of Jefferson County, Alabama, is a foretaste.

Maryland, Virginia, South Carolina, New Mexico and Tennessee have all been put on negative watch. California has had to raise an emergency $5bn loan. Nevada is spending half its tax-take on debt service costs, and Michigan 40pc. These states are hanging on by their fingernails.

Yet if disaster is an outside risk in America, it is an odds-on likelihood in Europe. It is already clear that the latest EU summit deal is too little to stop a spiralling crisis in confidence, let alone acknowledge that North and South have diverged too far to share a currency union. Spanish and Italian yields are back to pre-summit danger levels, and might fly out of control at any moment unless a lender-of-last resort steps in to guarantee the market.

The European Central Bank still refuses to do so, and the EFSF bail-out fund cannot legally do so until all national parliaments ratify the summit deal to widen its remit. Yet these chambers have shut down for the summer. Europe’s leaders have gone on holiday. The €440bn EFSF is in any case too small. The bond vigilantes broadly agree that the EFSF needs €2 trillion in pre-emptive firepower to forestall a twin crisis in Italy and Spain, though quite how France might pay for this without being drawn into the maelstrom itself is an open question.

Germany’s “triangulating” finance minister Wolfgang Schauble has once again over-promised in Brussels, only to retreat under pressure in Berlin. There will be no “carte blanche” for EFSF bond purchases. So will Germany do whatever it takes to uphold monetary union in its current form, or will it not? We are no wiser.

As the details dribble out from the summit deal, we can now see that Greece will enjoy no debt relief despite having been pushed into default. Citigroup said the net effect will increase Greece’s debt by a further 4pc of GDP to more than 160pc next year. Since this is obviously untenable, Greece will need a third rescue.

The EU has brought about the first sovereign default in Western Europe since the Second World War and set a fateful precedent without actually resolving the Greek problem. This is the worst of all worlds.

Moody’s cited the summit terms as a key reason why it put Spain on negative watch last week. “Pressures are likely to increase still further following the official package for Greece, which has signaled a clear shift in risk for bondholders of countries with high debt burdens or large budget deficits,” it said.

EU ineptitude - or rather, German, Dutch and Finnish unwillingness to face up to the implications of EMU - have raised the risk of a traumatic August crisis in Italy and Spain. EU leaders are bringing about exactly what they pledged to avoid.

The US cannot insulate itself against the consequences of Europe’s elemental EMU blunder, but it can mitigate the effects by restoring order in its own political house. The Fed has already bought a degree of insurance by gunning the money supply in advance. The executive institutions of the US government are viable and still functioning.

We can only pray that at least one half of the Atlantic system holds relatively firm. If both go down together, buy a shotgun and prepare for 1932.

* The Fed stopped publishing M3 in 2006 but private economists reconstruct the data from the components.